Fundamental Analysis - Evaluating Debt

Business managers are basically faced with two choices when determining how to finance the growth of their companies. They can incur debt financing, such as a demand loan, debenture, or mortgage, or alternatively, they can raise additional equity capital through public or private markets. Of course, a combination of debt and equity financing is another possibility. Business managers must carefully examine the dilution that would result from an equity offering vs. the principal and interest service requirements of a debt financing. Of course, careful consideration must be given to existing debt leverage. Given the critical nature of this decision on the future success of a company, investors are beginning to pay more attention to the method by which a company funds its growth initiatives.

There are a few simple tools that can be used to quickly evaluate the capital (debt and equity) structure of a company to ensure that the business is built on a solid foundation. The first evaluation that should be made is whether or not the company's capital structure matches its industry requirements and stage of development. The amount of debt that is acceptable for any given company will depend greatly on the extent to which its industry is capital intensive - to what extent equipment and other capital assets are required for its business. Clearly, a commercial real estate company will have substantially greater debt leverage than most software developers. Debt financing should generally be reserved only for companies that are generating cash flow from their operations. Otherwise, future principal and interest payments will have to be made from working capital which in turn will likely have to come from subsequent financings. Relying on the receipt of future financings to cover debt payments is a very risky proposition. Financiers recognize how critical such financings are to keep the company afloat and will leverage the company's desperation to get a better deal for themselves. This could mean higher interest rates, bonus shares, or other incentives which are generally not in the best interests of the company and its shareholders. Among companies that are generating operating cash flow, the level of debt selected should depend on a number of factors, including the stability and consistency of revenues and cash flows, the amount of hard assets backing the debt, etc.

INTEREST COVERAGE

All evaluations of a company's debt levels should include an examination of its interest coverage or "times interest earned" ratio. In fact, many analysts consider interest coverage to be the most important quantitative test on a company's debt service abilities. Very simply, this ratio tests a company's ability to pay the interest charges on its debt. More specifically, it measures how many times its interest charges are covered by its operating earnings. It is calculated as follows:

Interest Coverage =

(Net earnings before extraordinary items - "equity income" + minority interest + all income taxes + interest)

DIVIDED BY

Interest

It is important to take into account newly issued debt and the relevant future interest costs when looking at a company's ratio, especially if the company has historically operated with little debt on its books.

A ratio of 2, means that a company's earnings could decline 50% and it would still be able to service its interest costs (however, it might not be able to make its principal payments). A ratio of 4 means that a company's earnings could decline 75%, and it would still be able to make its interest obligations. The higher the ratio, the greater the margin of safety the company has if it experiences any events that negatively impact its earnings. The lower the ratio, the more risk the investor assumes.

What is considered an acceptable ratio varies depending on the company's industry, and the investor's or analyst's risk tolerance. As a general rule of thumb, most analysts look for an interest coverage ratio of at least 3 for most industrial companies. However, in practice, this ratio may not prove conservative enough for small-cap or emerging companies which tend to exhibit greater fluctuations in earnings on a percentage basis, and as a result, are more vulnerable to interest coverage problems if short-term events negatively impact their business. An assessment of the likelihood of earnings fluctuations must be made by the investor. If a high risk of earnings volatility is perceived, the investor should look for a higher interest coverage ratio, perhaps even as high as 6 or more if he wishes to be conservative. For utility companies and other industry groups that exhibit relatively stable earnings from year to year, a lower ratio is acceptable. It should be noted that a company may survive and even flourish with a low interest coverage ratio, especially if it is blessed with a strong working capital position. However, the investors must recognize the additional risk assumed when investing in such a company, and be prepared to monitor the company's earnings and debt servicing carefully.

As with most other ratios, it is worthwhile to look at the trend in the interest coverage ratio over several quarters or even a few years if the company has a long-term track record of profitability. A trend towards a higher ratio is obviously preferred over a movement towards lower and lower ratios which could signal impending problems. Given that bankruptcy frequently results from the failure of a company to meet its interest obligations, the interest coverage ratio is a quick tool which can help investors avoid some nasty surprises.

Of course, in most circumstances, a company must not only meet its interest obligations, but it must also pay down the principal of its debt. While the interest coverage ratio can give us a good idea of a corporation's ability to meet both interest and debt payments, it is frequently preferable to take one's examination a step further.

THE DEBT/EQUITY RATIO

Many analysts and accountants tout the use of the debt/equity ratio in analyzing debt. In reality, it has severe limitations, often yielding meaningless or highly misleading results, especially for companies in the first few years following commercialization of their product. It does have some value in revealing general debt risk, but does not have the ability to focus in on specific problems. The debt/equity ratio has more value when examined over a period of time. A deterioration in the ratio could reflect impending debt service problems. The higher the ratio, the greater the financial risk and the more difficult it will be for a company to attract additional conventional debt financing to fund its growth strategy. The debt/equity ratio is calculated as follows:

Total Short and Long-Term Liabilities

divided by

Shareholders' Equity

As a rough rule of thumb, many analysts look for a ratio of 0.50 or less for most industrial and technology companies. Remember of course, that certain industries are inherently more capital intensive than others and will require higher debt levels.

ASSET COVERAGE

Essentially, the asset coverage ratio measures how many times over the company could pay off its debt in the event that it sold all of its tangible assets at their carrying (book) value. It is calculated as follows:

Total Assets - deferred charges and intangible assets - current liabilities

divided by

Total short and long-term liabilities

This ratio also has severe limitations. Many assets may have little or no value if sold. Similarly, in the event of a liquidation or distressed sale, many assets may only fetch pennies on the dollar. For this reason, a ratio of at least 2 is generally said to provide a reasonable comfort level. The higher the ratio, the better.

While the above ratios have severe limitations, they are worth knowing and applying. Above, we explored some of the most common tools used to evaluate debt risk and a company's ability to handle its debt service payments. However, we also identified that many of the most frequently used ratios and tools have severe limitations. In the remainder of this article, we will explore 2 far more effective tools. They are so valuable as a predictive tool, I will not invest in a company without taking the time to make these relatively simple calculations. The premise behind these tools is simple: If a company has debt, at some point it will have to make debt service payments, whether they be interest payments, principal payments, or both. It can either fund these payments through its operating cash flow, by dipping into its cash reserves, or by selling assets.

As investors, the latter two options are generally regarded as unacceptable as they can result in an erosion of shareholders' equity and interfere with a company's ability to grow. If these alternatives are being used by a company, it has likely taken on debt financing too early in its life cycle (i.e. during the product development stage or initial stages of commercialization), it has taken on too much debt, or it is experiencing some sort of operational difficulties.

TOOL # 1 Compare annual cash flow from operations to principal and interest payments due within the next year.

If a company's operating cash flow can cover all of its debt service obligations, the company should be able to maintain all of its debt service obligations. As a result, the risk of insolvency is reduced considerably.

Operating cash flow is generally defined as a company's net income before extraordinary items; plus all non-cash expenses such as depreciation on capital assets, amortization of intangible assets, depletion, deferred income taxes, and minority interest; less non-cash income (equity income or other accounting gains).

A company's interest payments due within the next year can be estimated by multiplying its interest expense during the most recent quarter by 4. Of course, you should be careful to take into account recent changes to the company's debt structure in the event of an acquisition, debt repayment, or other noteworthy transaction. The principal payments due within the next year are generally found in the current liabilities section of the balance sheet under the heading "current portion of long-term debt," or something similar.

Clearly, a company's annual operating cash flow should exceed its debt service (principal and interest) payments required during the same period. A ratio of 2:1 is generally acceptable for most companies, although if you are risk adverse, you may prefer to select companies with an even greater level of coverage.

While comparing cash flow to debt service requirements, it is also important to subjectively review the maturity dates of certain debt obligations as well as the timing of interest payment dates to ensure that a company will have the appropriate amount of cash on hand to meet these payments when they fall due, especially if abnormally large payments are expected to fall due within the next year or two. Such payments typically result from the maturity of convertible debentures, or balloon interest payments. It is also important to look beyond a one-year time horizon despite the potential difficulty in projecting operating cash flow so far into the future.

TOOL #2 Debt / Cash Flow Ratio

This is another highly useful ratio, although in my opinion, it does not provide as much information as the above. It is particularly valuable in the evaluation of oil & gas stocks which often rely on operating cash flow to meet their exploration and development budgets and debt service payments. The ratio is calculated as follows:

Total Short and Long-Term Debt divided by Operating Cash Flow

As a benchmark, most analysts are comfortable with a ratio of 3 or less for most companies. The lower, the better.

No matter what method or methods are selected by the investor to evaluate the debt of a particular company, he must remember to keep updating his calculations each time new information, such as quarterly financial reports, become available. This is particularly true if a company fails to meet its earnings or cash flow forecasts, or if it takes on new debt for an acquisition or other expansion initiatives, etc.

Grant Robertson, B.B.A.

Disclaimer: The author is not a registered investment advisor. Accordingly, this article is presented for educational and information purposes only. Those seeking specific investment advice should consult a registered investment advisor. You are urged to consult your investment advisor before embarking on any new investment strategy as the strategies depicted in this article may not be suitable for all investors.